Boom in seed funding will leave 1000 startups orphaned

CB Insights report says 60% of startups raising seed rounds will not raise a Series A

Last month I had a thought: with all of the talk of the fiscal cliff, and the impact it was going to have on the economy, would it also have an effect on the amount that venture capitalists invested? In the course of writing that story, another problem facing venture financing came up a number of times: a Series A crunch, where the amount of money going into Series A round was dwindling, either due to VCs being able to raise less money to invest or too many companies being funded in the seed round than Series A funders could handle.

The truth appears to be the latter. The number of Series A deals have remained flat, while the seed deals have exploded.

“Despite the concerns about a crunch, the reality is that the level of Series A activity is holding steady. At the same time, the number of seed deals have exploded. As a result, the Series A Crunch is nothing more than excessive demand for a limited supply of Series A financings,” according to a just-released CB Insights report.

The number of seeds deals has indeed boomed, rising up to above 500 deals in the second and third quarter of 2012, far above the 388 seen in the first quarter.

The number of Series A deals, though, has actually remained steady this year, with 173 in the first quarter, then a slight rise up to 206 deals in the second quarter, before coming down again to 182 deals in the third quarter.

The larger number of seeded companies has just made it feel like there is a crunch due to higher amount of competition for companies to get their hands on that next level of cash.

Calling the process “natural selection,” CB Insights says that over 1,000 companies that were funded in the seed round will be “orphaned,” meaning that they will not be able to raise any more money.

On average, the report says, around 40% of companies that raise money in the seed round will raise money in later rounds.

If that number remains the same, there will be a larger number of companies that will not receive Series A funding, but that doesn’t mean that funding is down. Over $1 billion will be wasted being poured into these companies, but, of course, this is just a part of the process and the risk that is taken by funding a start up company.

“Seed investments are the riskiest bets an investor can make and the reality is most will not return money. Again, the death of startups and the loss of investment dollars is part of the process of separating the best companies and investors from those which aren’t,” says CB Insights, which also notes this may turn out to be a good thing.

“The eventual death of many of these companies may also help the tight labor market for other startups who are looking for capable and driven talent.”

The report found that while California led in seed investments from the beginning of 2009 to the end of 2012 with 1409, New York came in second, with 559.

Massachusetts, which came in third, only saw 273 seed deals,but has the highest rate of follow on funding, with 32% of companies raising money in later rounds.

New York, on the other hand, has seen a “seed boom which has buoyed the state’s investment activity for some time,” CB Insights wrote, which the report says will result in New York seeing the highest proportion of orphaned startups.